Some of Wall Street’s biggest names are raising the alarm that soaring inflation is coming soon. They are wrong — here’s why.

People are worried about inflation.

The Economist recently posted a podcast asking: “Will the pandemic usher in a new era of inflation?” Market based measures of inflation expectations have been steadily rising, meaning a sizable number of investors are mulling the possibility. Big Wall Street investors and economic names such as bond manager Jeff Gundlach has told his audience to beware of higher rates and inflation. 

But despite all this whinging, I am skeptical. Outside of a handful of sectors, consumer price inflation is likely to remain benign next year, even as economic growth strengthens. 

So why am I not too worried about a sudden increase in prices? A few reasons

First, inflation is a process that tends to move slowly outside of commodities. Indeed, much of the upside surprise in core inflation since April has been in these so-called flexible prices. That is, prices for goods that tend to change rapidly alongside current market conditions. 

Early in the pandemic, production was shut even as consumers continued spending, depleting inventories — or the backlog of goods businesses hold to meet consumer demand. As a result, prices for goods such as cars, furniture, and appliances rose sharply. As production normalizes and inventories replenish, the strong price gains in these kinds of goods will moderate.

Neil Dutta

Second, prices that tend to be “sticky” – relatively slow to change – have been slowing down. Because sticky prices tend to move slowly, it makes sense to assume that they are set with expectations for inflation in mind. Sticky prices tend to be quite useful in telling us about the outlook for underlying inflation. The news here is not exactly pointing to runaway inflation anytime soon: core sticky CPI has slowed to 1.79%, a one percentage point drop since February. 

Neil Dutta

Speaking of sticky prices, given the rapid increase in home prices over the last several months, it feels natural to wonder if higher home prices will find their way into consumer price inflation. I’m skeptical this happens anytime soon. Home prices don’t directly feed into consumer prices — since it is considered an asset. Instead rents are imputed based on the rent homeowners forgo by living in their home as opposed to renting it out.

Over time, higher home prices should lead to higher rents, putting upward pressure on CPI. After all, landlords will be reluctant to cut rents if the underlying value of the asset is appreciating. However, renting also competes with home-owning – a substitution effect. If home owning becomes more attractive, the rental market may suffer, pushing rents lower even as home prices climb. 

It is pretty clear homeownership is on the rise today, likely weighing on rental demand. At the moment, my sense is that the rise in home prices will be more likely to lead to lower rents than higher – the substitution effect is dominant. This is important since rents constitute such a large chunk of consumer prices to begin with – about one-third of CPI and almost one-fifth of PCE (the other primary measure of inflation).

Third, some of the increase in inflation this year has been due to healthcare services. There are some issues of scope in how medical care services are calculated in CPI versus PCE, but the PCE price index includes payments made on behalf of people. The PCE healthcare price index has jumped about 0.4 percentage points over the last year. The reason behind the increase is an increase in Medicaid and Medicare reimbursement rates for COVID patients. This is not exactly an issue of real inflation pressures. As the pandemic subsides, so will the healthcare inflation.

Lastly, it is hard to see why the recovery in the labor market next year will be particularly inflationary. After all, we’ve seen a significant negative supply shock to the labor market — that is fewer people are available to work — this year as many parents have stayed at home while their kids do remote learning. School reopenings will act as a positive supply shock for the labor market, providing a lift to the pace of jobs growth without much wage pressure.

Interestingly, the labor force participation rate for those aged 16 to 24 has already returned to early 2019 levels – a rapid recovery since February. By contrast, the participation rate for those aged 25 to 44 is lower than it was at any time since the financial crisis. This makes sense since this age cohort is the one most likely to be at home with kids for remote or distance learning. At any rate, the reopening of schools will make it easier for firms to find workers. 

Neil Dutta

None of this is to say that the economy may not face pockets of price pressure next year. There might be insatiable demand for recreational services (flights, hotels, casinos, theme parks, dining out, etc). That would be welcome, but would not really amount to much since these areas only make up 5% of total consumption. And, to the extent that prices rise in this area, people would probably compensate by cutting back in other areas like goods consumption, pushing the prices for those things down. 

In short, the inflation backdrop is likely to remain benign and that in turn, will likely reinforce the anchoring of the front end of the yield curve.